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Survival Of The Fittest

In the indexing and ETF world, 2012 may be remembered as the year ETF closings reached sufficient numbers to dominate industry gossip and news about ETFs. IndexUniverse’s ETF Watch lists about 100 ETF closures in 2012, almost twice the annual pace seen in 2008-2010 during the financial crisis and recession. There is little chance we will run out of ETFs or stop launching new ones any time soon: The total number of ETFs continues to expand, with nearly 180 added in 2012, and money continues to flow into ETFs, both new and old. By now, some 20 years after the launch of the SPDR S&P 500 ETF (NYSE Arca: SPY) kicked off the rise of the ETF industry, most new ETFs— and recently closed ones— are based on strategy indexes rather than broad-based market indexes. Strategy dominates the new issues because there are few, if any, markets left that aren’t already covered by ETFs. Further, strategy indexes— and hence the ETFs linked to those indexes—focus on various investor interests such as dividends or low volatility. Digging into the nature of strategy may explain the 2012 rise in ETF terminations.

While we shouldn’t ignore some of the financial factors cited for ETF closures—rising operating expenses; increases in the minimum size needed to break even; or competition among ETF issuers—understanding the nature of strategies and the indexes that track them is important for understanding why some ETFs survive and others fade away.

Financial and economic research going back several decades focuses on why some stocks tend to outperform the market. The results of this research are the raw material of strategy indexes. Many investors are familiar with ideas that small-cap or value stocks tend to outperform large-cap or growth stocks. The more formal statement of these arguments is the three-factor model of Gene Fama and Ken French,1 who identified size measured by market capitalization and a value bias measured by the ratio of book value to market value and then added market performance as the third factor driving stock performance. Later work by Mark Carhart2 introduced momentum measured by the difference between short-term and intermediate-term performance as a fourth factor. Recent research has expanded some of these ideas with different measures of value or momentum and with new factors such as volatility or liquidity. The three- or four-factor models underlie the first generation of strategy indexes focusing on combinations of growth or value and large-, mid- or small-cap stocks and momentum.

These efforts were only the beginning of strategies. Other factors soon joined, including dividends, specific sectors or industries, mergers, acquisitions, spinoffs and other corporate actions or such company characteristics as family ownership or social policies. Strategy indexes are attempts to exploit times when the market deviates from the theory that all stocks offer the same returns after adjustment for risk and correlation. Some strategies—for example, buying stocks in only one sector—have limited lifetimes, since the market is constantly evolving. Other strategies seek longer lifetimes and more staying power; some claim to do well in various markets.

All strategies face three challenges that could limit their performance. An ETF based on a strategy that underperforms is living on borrowed time. Consider an ETF that holds stocks in only one sector: Markets shift over time, and what works one day may fail miserably the next day. Financial stocks were shunned in 2007-2009 but gained twice as much as the S&P 500 in 2012.